Ronald W. Howland, Jr. & Marilee R. Howland

United States Tax Court
T.C. Memo. 2022-60RONALD W. HOWLAND, JR. AND MARILEE R. HOWLAND,
Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
—————
Docket No. 17526-19. Filed June 13, 2022.
—————
Scott St. Amand and Harris L. Bonnette, Jr., for petitioners.
Miriam C. Dillard and A. Gary Begun, for respondent.
MEMORANDUM OPINION
WEILER, Judge: Petitioners seek redetermination of the
deficiency and penalty respondent determined in a notice of deficiency
for tax year 2016. The issues for decision are (1) whether petitioners are
entitled to a home mortgage interest deduction of $103,498 claimed on
Schedule A, Itemized Deductions, of their Form 1040, U.S. Individual
Income Tax Return, for tax year 2016 and (2) whether petitioners are
liable for the accuracy-related penalty under section 6662(a). 1
Background
On December 8, 2021, the parties moved to submit this case fully
stipulated under Rule 122, and the motion was subsequently granted
1 Unless otherwise indicated, all statutory references are to the Internal
Revenue Code (Code), Title 26 U.S.C., in effect at all relevant times, all regulation
references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all
relevant times, and all Rule references are to the Tax Court Rules of Practice and
Procedure. All dollar amounts are rounded to the nearest dollar.
Served 06/13/22
2
[*2] during the Court’s Jacksonville, Florida, remote trial session. The
evidence in this case includes the parties’ Stipulation of Facts, and those
facts are so found. Petitioners resided in Florida when they filed their
Petition.
In 2007 petitioners executed a credit agreement with Haven
Trust Bank, consisting of a promissory note and mortgage secured by
their principal residence, with respect to a line of credit up to $390,000
(credit agreement). This credit agreement in favor of Haven Trust Bank
was secondary to petitioners’ first mortgage loan held by Countrywide
Home Loans. Under the terms of the credit agreement held by Haven
Trust Bank, petitioners’ payments are applied first to interest and then
to principal.
Haven Trust Bank was closed in 2010 and entered receivership
with the Federal Deposit Insurance Corporation (FDIC), in which the
FDIC entered into a loss-share transaction with First Southern Bank
related to the assets of Haven Trust Bank, whereby petitioners’ loan
with Haven Trust Bank was acquired by First Southern Bank.
In June 2014 First Southern Bank merged with CenterState
Bank. Since petitioners had not made any payments on the Haven Trust
Bank credit agreement, First Southern Bank filed a verified complaint
for foreclosure (foreclosure complaint) in the Seventh Judicial Circuit
Court for St. Johns County, Florida (circuit court). When the foreclosure
complaint was filed, petitioners owed $377,060 in principal on the credit
agreement, plus accrued interest, fees, and other charges. In the
foreclosure action First Southern Bank sought an award from the circuit
court for the full amount due from petitioners, including the right to
foreclose on petitioners’ residence based on the granted credit
agreement.
As part of the foreclosure complaint, the circuit court entered a
summary final judgment, resulting in a foreclosure sale of petitioners’
residence on July 28, 2016. CenterState Bank was the highest bidder at
the foreclosure sale and acquired the residence with a bid of $321,000.
At the time of the foreclosure sale, the sum of the accrued interest on
the credit agreement was $100,607.
On June 9, 2016, a second foreclosure complaint regarding
petitioners’ residence was filed in the circuit court by the first mortgage
holder, Bank of New York Mellon, as successor in interest to
Countrywide Home Loans. Bank of New York Mellon claimed a balance
3
[*3] due of principal, interest, late charges, attorney’s fees, and other
permitted expenses of $247,046.
On December 30, 2016, CenterState Bank sold petitioners’
residence to third parties for $594,000. No Internal Revenue Service
(IRS) Form 1098, Mortgage Interest Statement, was issued to
petitioners for tax year 2016 for the home mortgage interest in question.
There is no evidence in the record as to how the sale proceeds of $594,000
were applied to petitioners’ debts with First Southern Bank and Bank
of New York Mellon.
Petitioners timely filed their joint 2016 Form 1040, claiming a
home mortgage interest deduction of $103,498 on Schedule A. On
October 1, 2018, the IRS sent petitioners an automatically generated
Letter 566–S and Form 14809, Interest You Paid, requesting an
explanation of their claimed home mortgage interest deduction. On
November 26, 2018, the IRS sent petitioners additional letters, to which
they responded (through their representative) by providing the IRS with
documents on February 1, 2019.
Revenue Agent (RA) Beverly Starks was assigned examination of
petitioners’ 2016 Form 1040 on April 23, 2019. On May 8, 2019, RA
Starks completed the “Penalty Substantial Understatement Lead
Sheet” (penalty lead sheet), and on May 9, 2019, the IRS issued to
petitioners (with a copy to their representative) IRS Letters 692–M and
937(SC), including Form 4549, Income Tax Examination Changes, and
Form 886–A, Explanation of Items. RA Starks’s immediate supervisor,
Carmen Grimes, approved the penalty lead sheet on May 9, 2019.
Discussion
I. Summary of the Parties’ Arguments
Petitioners argue that the foreclosure of their mortgage
constituted a taxable sale or exchange. Next, petitioners contend the fair
market value of the residence is equal to the price that a willing buyer
paid shortly after the foreclosure. On the basis of the terms of the credit
agreement, petitioners contend the amount CenterState Bank received
in the foreclosure proceedings and specifically in the subsequent sale to
a third party should be applied first to their outstanding interest owed,
and then to principal. Finally, petitioners oppose the imposition of the
penalty under section 6662(a) on two grounds: (1) the IRS failed to
obtain timely supervisory approval before the initial determination to
4
[*4] assess a penalty and (2) petitioners had reasonable cause for the
underpayment and acted in good faith.
On the other hand, respondent argues that petitioners are not
entitled to the home mortgage interest deduction claimed on their 2016
Form 1040. According to respondent, the foreclosure bid did not cover
the principal balance due from petitioners to CenterState Bank, after
payment of the first mortgage balance due to Countrywide Home Loans.
Accordingly, no interest amount was paid to CenterState Bank at the
time of the foreclosure sale. Finally, respondent contends that
petitioners are liable for the accuracy-related penalty pursuant to
section 6662(a) since an underpayment of tax exists and petitioners have
not shown that any exception to the penalty applies in this case.
II. Burden of Proof
Generally, the Commissioner’s determinations are presumed
correct, and the taxpayer bears the burden of proving them erroneous.
Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). The burden of
proof may shift to the Commissioner if the taxpayer establishes that he
or she complied with the requirements of section 7491(a) to substantiate
items, to maintain required records, and to cooperate fully with the
Commissioner’s reasonable requests. Petitioners do not contend, nor
does the record suggest, that the burden of proof should shift to
respondent as to any issue of fact; accordingly, the burden will remain
with them. 2 See I.R.C. § 7491(a)(1).
III. Relevant Law
Generally, a taxpayer may claim a deduction for “all interest paid
or accrued within the taxable year on indebtedness.” I.R.C. § 163(a).
Notwithstanding the limitations on deductions for personal interest, see
I.R.C. § 163(h), home mortgage interest on indebtedness secured by a
mortgage on a taxpayer’s residence may be deductible as qualified
residence interest (QRI), see I.R.C. § 163(h)(2)(D). Interest is fully
deductible if it meets the statutory requirements. See I.R.C. § 163(h)(3).
Interest is deductible only when paid or accrued during the tax
year. See I.R.C. § 163(a). A cash basis taxpayer can deduct interest only
when paid, either by cash payment or its equivalent (including
2On the basis of the record before us, we are required to consider which party
bears the burden of proof in reaching our decision. Cf. Gibson & Assocs., Inc. v.
Commissioner, 136 T.C. 195, 221 (2011).
5
[*5] transferring property to the lender in payment). Helvering v. Price,
309 U.S. 409 (1940); Hilsheimer v. Commissioner, T.C. Memo. 1976-284,
35 T.C.M. (CCH) 1275 (denying an interest deduction to cash basis
taxpayer for interest payments that were not made). 3
IV. Interest Amount Paid
There is no dispute whether section 163(h) governs the primary
issue for decision in this case. Rather, the parties dispute whether
petitioners are entitled to a home mortgage interest deduction based on
the amount of QRI paid for the 2016 tax year. To answer this question,
we must determine whether petitioners paid interest in the year at
issue.
To determine whether a particular payment is appropriately
characterized as interest, we begin by considering the fundamental
nature of the transaction in question. In many cases—as in this one—
the existence of indebtedness is clear and undisputed. When the
existence of indebtedness is established, the next hurdle is whether a
particular payment is a payment of interest. The Supreme Court has
defined interest as a “compensation for the use or forbearance of money.”
Deputy v. du Pont, 308 U.S. 488, 498 (1940).
The general rule in this area is that voluntary partial payments
made by a debtor to a creditor are, in the absence of any agreement
between the parties, to be applied first to interest and then to principal.
See Lackey v. Commissioner, T.C. Memo. 1977-213, 36 T.C.M (CCH) 890.
However, an exception to this general rule exists in the case of an
involuntary foreclosure of mortgaged property where the evidence
“strongly indicates” that the mortgagor is insolvent at the time of
foreclosure. See Newhouse v. Commissioner, 59 T.C. 783, 789 (1973).
Rejecting the interest first rule, we held in Newhouse and Lackey
that no portion of the proceeds from either of the foreclosure sales
therein was allocable to interest since the debtors were insolvent. While
in Estate of Bowen v. Commissioner, 2 T.C. 1 (1943), we applied the
proceeds from a foreclosure sale to interest first and then to principal
3 The time in which interest is paid or accrued depends on the taxpayer’s
method of accounting; here, it is undisputed that petitioners use the cash method of
accounting and may deduct interest only when it is actually paid.
6
[*6] where the debtor was not shown to be insolvent and the payments,
in spite of foreclosure, were said to be voluntary.
In this case the payments were not voluntary; however, there is
no evidence petitioners were insolvent at the time of the foreclosure.
Furthermore, unlike Lackey and Newhouse, this case involves a clear
written agreement—namely the credit agreement—between the lender
and petitioners that repayments on the note are applied first to interest.
Consequently, we find our decisions in Lackey and Newhouse to be
distinguishable. 4
Both parties cite Helvering v. Midland Mut. Life Ins. Co., 300 U.S.
216 (1937), and Blossom v. Commissioner, 38 B.T.A. 1136 (1938), in
support of their arguments. The core dispute in these cases relates to
the application of the proceeds from the foreclosure sale of petitioners’
home. Respondent does not dispute that the amount realized under the
foreclosure proceeding by CenterState was $594,000; 5 rather,
respondent contends that petitioners ignore the property’s first
mortgage of $247,046, resulting in a net difference of $346,954—which
is less than the principal balance of $377,060 due to CenterState, and
consequently petitioners paid no interest.
We agree, in part, with respondent’s argument. While respondent
is correct that CenterState did not realize the full $594,000, but rather
received only $346,954 after the first mortgage was satisfied, we cannot
definitively conclude that CenterState received only the payment of
principal from petitioners.
It is undisputed that the principal balance due to CenterState
was $377,060; however—as petitioners argued—under the terms of the
credit agreement, delinquent payments were to be first applied to
4 Respondent is correct that in Newhouse we declined to accept a taxpayer’s
argument seeking to designate income as interest income to a creditor on a foreclosed
property when the debtor was insolvent. Newhouse, 59 T.C. at 790. However, in
Newhouse we recognized that there was no agreement directing the manner of
apportionment of the proceeds from a foreclosure sale in the event the total proceeds
were insufficient to cover both unpaid principal and accrued interest. Id. at 784–85.
We find the facts here to be distinguishable since there is no evidence in the record
that petitioners were insolvent at the time of the foreclosure.
5 Petitioners, in their briefing, contend the foreclosure sale of their residence
to third parties constituted a taxable sale or exchange, and the amount petitioners
realized on the foreclosure sale was $594,000, the amount paid by third parties to
CenterState Bank. Respondent did not dispute this argument in his briefing.
7
[*7] interest due from petitioners, rather than to principal. Therefore,
we must analyze the terms of the foreclosure action and its tax
implications here.
Per the judgment issued by the circuit court, the total amounts
due included principal of $377,060, interest computed to March 8, 2016,
of $65,482, appraisal fees of $650, and deferred interest of $26,139.
These four amounts total $469,331. At the time of the foreclosure sale,
the sum of the accrued and deferred interest on the credit agreement
equaled $100,607. Petitioners contend that CenterState, as successor in
interest and holder of the promissory note, was contractually bound to
apply the foreclosure proceeds first to interest and second to principal.
Respondent, however, argues that these payment provisions found in
the promissory note are not applicable here in the context of a
foreclosure sale.
V. Petitioners’ Burden of Proof
As discussed above, income tax deductions and credits are a
matter of legislative grace, and the taxpayer generally bears the burden
of proving that he is entitled to any deduction or credit claimed. Rule
142(a); Deputy v. du Pont, 308 U.S. at 493; New Colonial Ice Co. v.
Helvering, 292 U.S. 435, 440 (1934).
During briefing petitioners acknowledged that the amount of
outstanding interest at the time of the foreclosure action was $100,607,
and they argue that the interest portion on their credit agreement to
CenterState was paid in full. 6
The record before us is silent as to how CenterState applied the
funds received and whether petitioners owe any remaining principal
balance. These facts (if favorable) could support a finding that
petitioners in fact paid home mortgage interest (in some amount)—
rather than repaying principal balance. However, statements in briefs
do not constitute evidence. Rule 143(c); Evans v. Commissioner, 48 T.C.
704, 709 (1967), aff’d per curiam, 413 F.2d 1047 (9th Cir. 1969);
Chapman v. Commissioner, T.C. Memo. 1997-147; Berglund v.
Commissioner, T.C. Memo. 1995-536. Pertinent facts missing from the
stipulation merely mean that the party bearing the burden of proof has
6Petitioners now contend that they are entitled to a QRI deduction of $100,607.
It remains entirely unknown how petitioners calculated their original claimed QRI
deduction of $103,498.
8
[*8] failed to sustain the burden of showing them. See Evans, 48 T.C.
at 709.
Petitioners bear the burden of proof and must show, by a
preponderance of the evidence, that they are entitled to a home
mortgage interest deduction of $103,498, or some other amount. For the
reasons discussed above, we conclude that petitioners have failed to
meet their burden. Accordingly, we will sustain respondent’s
determination to disallow this deduction claimed by petitioners.
VI. Section 6662(a) Penalty
We turn now to respondent’s determination that petitioners are
liable for the accuracy-related penalty under section 6662(a).
The accuracy-related penalty does not apply to any portion of an
underpayment if it is shown that there was reasonable cause for the
taxpayer’s position and that the taxpayer acted in good faith with
respect to that portion. I.R.C. § 6664(c)(1); Treas. Reg. § 1.6664-4(a). The
determination of whether a taxpayer acted with reasonable cause and
in good faith is made on a case-by-case basis, taking into account all the
pertinent facts and circumstances, the most important of which is the
extent of the taxpayer’s effort to assess his or her proper tax liability for
the year. Treas. Reg. § 1.6664-4(b)(1). Circumstances that may indicate
reasonable cause and good faith include an honest misunderstanding of
law that is reasonable in the light of all of the facts and circumstances.
Id.The taxpayer bears the burden of proof with respect to reasonable
cause. Higbee v. Commissioner, 116 T.C. 438, 446 (2001). The mere fact
that we have held against petitioners on the substantive issue does not,
in and of itself, require holding for respondent on the penalty. See
Hitchins v. Commissioner, 103 T.C. 711, 719-20 (1994) (“Indeed, we have
specifically refused to impose . . . [a penalty] where it appeared that the
issue was one not previously considered by the Court and the statutory
language was not entirely clear.”).
We agree with petitioners that they made a reasonable attempt
to comply with the Code in circumstances involving a complex issue. We
note that respondent has not referred us to, nor have we found, any
cases that have directly answered the question before us. Accordingly,
in the light of all the facts and circumstances, we find that petitioners
acted reasonably and in good faith with respect to the underpayment for
9
[*9] the 2016 tax year and are not liable for the accuracy-related penalty
under section 6662(a).
We have considered all of the arguments that the parties made
and to the extent they are not addressed herein, we find the arguments
to be moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered under Rule 155.